The pandemic was something of a watershed moment for Rolls-Royce (LSE:RR) shares. And not in a good way. The stock collapsed on the back of falling revenues in its civil aviation segment — the company’s largest business area.
Currently, Rolls-Royce is trading for 93p a share. That’s up 4% over the week, but down 68% versus 2019.
For a while, I’ve been saying Rolls-Royce is undervalued, and increasing my stake in the company. But now I think there are signs this stock is ready for take-off. Here’s three reasons why Rolls-Royce might be about to soar.
Improving sentiment towards Rolls-Royce
Rolls-Royce was recently described by Morgan Stanley as “the clearest example of mispricing” in its coverage. I agree, and I think the big issue is the market sentiment towards the British engineering firm, particularly related to negative press around the civil aviation industry and ‘travel chaos’.
But the Farnborough Airshow this week provided Rolls-Royce and its partners in civil aviation the chance to change the narrative. Big orders, which we knew about in advance, were placed for planes, and Rolls was able to showcase its next generation technology, including its prototype of its UltraFan engine. The engine is 25% more efficient than its first generation Trent engines.
The stock is up 4% since the airshow started.
A market recovery
Global markets have been very averse to risk in 2022, and that’s pushed prices down across the board. There are clearly some things holding the market back, including Russia’s war in Ukraine and concerns over gas supplies.
But a recovery is coming. I feel it’s just a matter of time.
Particularly when looking at the FTSE 100, valuations are low and many stocks, like Rolls-Royce, appear undervalued. Personally, I think valuations have reached a place where they can’t go much lower. Just look at Lloyds and Barclays.
So unless we see new market shocks, I think the market, and Rolls-Royce, could be steadily pushing upwards.
Booming defence sector
We haven’t heard much from Rolls about the defence sector since Russia invaded Ukraine, but I’m expect business to be booming. The group recently said that the defence products it sold were delivered and maintained over decades, meaning individual geopolitical events don’t have an immediate impact on the business.
However, Rolls-Royce also said that increased government spending on defence underpinned long-term growth in the sector.
We do know that there is a backlog of orders. When we get more information on the segment’s performance, I think it’ll be very good news, and will give the share price a considerable boost.
Headwinds
Despite the above, there are several headwinds for Rolls-Royce. First among those is debt. As of February, net debt stood at £5.2bn. Business sell-offs should bring in around £2bn, which will help reduce debt to manageable levels.
In fact, the low valuations are reflective of the impact of debt on the balance sheet. The company currently trades with an exceptionally low price-to-sales ratio of just 0.58.
There’s also going to be concerns about Covid-19 going forward. A resurgent virus could still impact civil aviation and, consequently, Rolls’s revenue from the sector.